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How to Beat the Market

You need to do these four things to even give yourself a chance.

Every day, something incredible happens. Investors around the world trade millions of shares worth billions of dollars. Some are working alone, others in teams, while the most "advanced" let computer algorithms do the heavy lifting.

All of these competing forces make it difficult to beat the market. That being said, a select few have routinely been able to accomplish just that. And we believe that, given the right motivation and temperament, beating the market is entirely possible for the individual investor. In fact, we believe that because you only have one client to please (yourself), and can keep your eye trained on the long run, beating the market isn't an impossible task.

Of course, it requires some research on your part. Let this article be the starting point in your own journey toward beating the market.

Image source: Getty Images.

What is "the market"?

When people talk about "the market," they are almost always referring to the S&P 500. This index comprises 500 of the largest publicly traded companies based in the United States. It includes some companies you're likely very familiar with, like Amazon and Apple, and some that you're not, like Duke Energy and Edwards Life Sciences.

The business done with these companies represents such a large swath of American commerce that the S&P 500 has become a proxy -- or a somewhat accepted representation -- for the overall U.S. economy.

There are other indexes as well. The Dow Jones Industrial Average is very popular, but it follows just 30 of the largest companies in America, and it has an odd weighting system. The Nasdaq Composite is also a popular index. Though it contains almost 3,000 stocks, it is heavily skewed toward technology companies. While those companies are becoming a bigger and bigger part of the economy, the index fails to represent other massive industries such as retail and finance.

What does "beating the market" mean?

When investors talk about "beating the market," they mean getting returns -- over time -- that are higher than what the broader market achieves. In some ways, beating the market not only leads to more money in your account, but also earns you a badge of honor: It means you've chosen individual stocks, bonds, or funds that have performed better than average.

One caveat to keep in mind is that you can lose money and still beat the market. For instance, if you lost 20% of your portfolio in 2008, that wouldn't have been fun, but you still would have beaten the market by 18 percentage points.

And just because you get positive returns doesn't mean you "beat" the market. For instance, an investor who earned 20% in 2013 would likely have been happy, but he or she would still have lost to the market, which returned 29% during the calendar year.

What does the market normally return?

If we back-test all the way back to 1871, the S&P 500 has a compound annual growth rate (CAGR) of 9.15%. In plain English, this means that investors who have been in the market for the long haul have seen their portfolios grow by an average of 9.15% every year.

To give you an idea of how much a 9.15% return can grow your wealth over time, let's assume that you invest $1,000 this year, invest $1,000 more every year for 40 years, and earn the market average of 9.15% per year. After these 40 years, you'll have $384,000!

All you would have to do is invest less than $3 per day. You would need to do literally nothing else, and you'd end up with hundreds of thousands of dollars. That's the magic of compounding.

However, there are three very important caveats.

1. The market's historical return of 9.15% includes reinvested dividends

Dividends are payouts you get every quarter (generally, though they may be more frequent or less frequent) for owning shares of certain companies. Not every stock pays a dividend. Typically, it's larger, more established companies that can afford to use their excess cash to reward shareholders with a dividend. When returns are calculated for reinvested dividends, this assumes that said dividends are part of an automatic dividend reinvestment plan (DRIP). In such plans, your brokerage automatically uses the dividends you receive to purchase additional shares -- or even fractional shares -- of said company.

For example, Apple stock costs $220 per share as of this writing. If you own shares, of course you hope that the price will go up and earn you a profit. But you'll also make money by collecting dividends. Right now, you'll get a payment of $0.94 per quarter -- or $2.92 per year -- for every share you own. It will simply show up in your brokerage account.

While dividend payments might make a small difference in your gains in the short term, they can add up to make a huge difference in the long run. For instance, if we remove the long-term effects of dividends from our assumptions, the market has historically returned 4.45% per year.

That's an enormous difference. It cuts the yearly return by over half! Instead of $384,000, you'd have a much more modest $110,000 at the end of 40 years.

2. We're not accounting for inflation

Over time, things get more expensive. Your grandparents may have been able to buy a can of soda for five cents. I went to pro baseball games with a $4 ticket when I was a kid. Both seem like fantasy now. That's because of inflation.

Over the past 100 years, inflation has averaged 2.82% per year. In other words, a banana that costs $1 today will likely cost $1.03 next year.

The 9.15% historical return of the S&P 500 does not factor in the role of inflation. In other words, even if we end up with $384,000 in 40 years, it won't buy nearly as much as $384,000 today.

If we factor in the role of inflation but include dividends, the market's return is 6.96% per year. This means our $1,000-per-year saver will have the equivalent of $211,000 in 2019 dollars after 40 years, assuming an inflation rate of 2.82%. Here's why this is helpful: It tells us that this person's nest egg will purchase the same amount that $211,000 will today -- even though the total might $384,000.

3. You must be invested for the long haul to achieve those returns

The market can be incredibly volatile: wars, recessions, natural disasters, breakthrough technologies -- these are all unpredictable events that can have huge effects on the market's return in any given year.

If we go all the way back to when the data starts -- 1871, to be exact -- there are only six years in which returns came in between 8% and 11%. That's six out of 146 years! And yet the CAGR was still 9.15%.

Here's what that volatility looks like.

Chart by author. Data sources: MoneyChimp, Robert Shiller, Yahoo! Finance. Returns include dividends and do not account for inflation.

This is why staying invested for the long term is the best way to get that 9.15% return: If you invest over a shorter time frame, you could get outstanding returns -- or abysmal ones. Over time, however, they tend to even out.

Why should you try to beat the market?

So if you could potentially earn 9.15% every year by simply investing in an index fund such as the SPDR S&P 500 Exchange Traded Fund (NYSEMKT:SPY) -- a fund that simply aims to get the exact same return as the market, minus a small expense fee -- then why would you try to beat the market by doing otherwise?

That's a great question, and the honest answer is that most people shouldn't try to beat the market. It opens you up to the possibility of severe losses, as well as the emotional strain of knowing that you might be making a bad financial choice for you and your family.

That's why we often suggest low-cost index funds -- which, generally speaking, try to match the market -- for those who want a hands-off approach to investing.

The four simple rules to beating the market

If you're trying to beat the market, you'll be trying to beat a host of other investors -- and their automatic, high-speed trading computers -- over time. And there's no one-size-fits-all approach to beating the market.

After all, if anyone published a foolproof way to beat the market, and it was adopted en masse, then that method would then come to represent "the market."

That being said, there are four basic principles you need to follow if you want to beat the market.

Market downturns happen all the time. The only way to make sure you can ride them out is to make sure your basic needs will be met no matter the investing climate.

2. Don't "be" the market

There are huge benefits to diversification. By spreading your portfolio out across several stocks in several industries, you avoid a cardinal sin: putting too many of your eggs in one basket. If you have 50% of your portfolio in a single stock, and that stock goes bust, then you've just lost half your nest egg.

But there's a flip side to be equally wary of: If your goal is to beat the market, you can't "be" the market. In other words, if your portfolio more or less represents the S&P 500, you'll never achieve outperformance.

This is a tricky balancing act that requires a great deal of reflection: You don't want to be reckless and let a few stock positions create make-or-break situations for your nest egg.

And yet, research has shown that over the past 90 years, just 4% of stocks have accounted for all of the market's gains. If you get your hands on one of those stocks and give them a fair share of your portfolio, you can easily beat the market.

Everyone will have their own solution to this problem. Below, I offer up my approach:

I let my "winners" keep on growing until they get to be between 20% to 25% of my portfolio (this has only happened with one stock). Once that threshold is crossed, I start to trim so that I don't have too many eggs in one basket.

The stocks in which I have the greatest conviction get at least 3% of the capital in my portfolio.

In general, my top 10 holdings account for three-quarters of my stock portfolio.

Of course, it's worth mentioning that I still have over 25 years until I reach retirement age, and I can afford to ride out market corrections and wait for the long-term trends to tilt in my favor. Those closer to retirement don't have that luxury, so they may choose to invest more conservatively.

3. Don't pay high fees

The fees you pay for your investments seem so tiny. A load fee of 2% here, an expense ratio of 1% there -- it doesn't sound like much for a mutual fund to charge.

But do the math, and you'll quickly see otherwise. In 2014, Motley Fool writer Morgan Housel told the story of a family friend who had accumulated a few million dollars and thought nothing of the 1.5% management fee she paid every year.

Then he broke it down for her: If her portfolio was $2 million, she was paying her manager $30,000 per year.

It was literally the single largest line item on her budget. More than her mortgage, more than her food bill, more than she spent on travel, clothes, entertainment, gifts, medical care, cars, and tuition for her kids.

But it doesn't stop there: Investment fees are a double-whammy. Not only does paying fees deplete your nest egg, but the lost money won't have the chance to grow in your portfolio either. Viewed through that lens, the fees are even more onerous for younger investors, who lose decades of compounding to such fees.

In general, investors should shoot for funds that have no "load fees," or fees paid simply for opening a position in the fund. They should also look for funds with expense ratios below 1% -- and the lower they are, the better.

Of course, if you do your own investing, you don't need to worry about paying professional stock-pickers. However, there are still two expenses to consider: trading fees and taxes.

As for trading costs, you should only buy stocks when the fee you pay for doing so is no more than 2% of your overall purchase. In other words, if your broker charges $10 per trade, you should make sure you're investing at least $500 in that trade. Further, by taking a long-term, buy-to-hold approach, you'll keep your trading costs very low.

On the taxes front, there are several considerations to keep in mind. It's wise to put your first investment dollars into tax-advantaged accounts. This includes:

401(k)s or 403(b)s: These are offered by private and public employers, respectively. You'll have fewer investment options with these accounts, but on the bright side, most employers that offer them will also match a portion of your contributions. That's free money that you should not turn down.

401(k)s and 403(b)s come in two basic varieties: traditional and Roth. In the case of a traditional account, your contributions are deducted from your taxable income, lowering your tax bill for the current year. However, the withdrawals you make in retirement will be subject to income tax. In the case of a Roth account, your contributions are not tax-free, but you can withdraw funds in retirement without paying income tax on them.

Workers are allowed to contribute up to $19,000 to a 401(k) or 403(b) in 2019. Those who are aged 50 or older can also make an additional "catch-up" contribution of up to $6,000.

Individual retirement accounts (IRAs): These also come in traditional and Roth varieties, and they largely get the same same tax treatment as a traditional 401(k) or 403(b). There are a few key differences, though. On the downside, there's no employer match, and the contribution limit for 2019 is much lower at $6,000, or $7,000 for those aged 50 and up. The upside is that you have the freedom to invest in whatever stocks or funds you choose.

Roth IRAs also have an additional advantage: You can withdraw your contributions (but not any earnings on those contributions) at any time without penalty.

Bear in mind that IRAs have limits on how much of your contribution may be tax-deductible (in the case of a traditional IRA) or whether you can contribute at all (in the case of a Roth IRA).

Health savings accounts (HSAs): If you have a high-deductible health plan that qualifies for an HSA, it can be a great way to save for retirement. The money you put into an HSA is tax-deductible, and the distributions -- so long as they're used on qualifying medical expenses -- are also untaxed. The one drawback is that you're generally limited in your investment options to specific funds. In 2019, people with qualifying plans can contribute up to $3,500 (individuals) or $7,000 (family).

Coverdell Education Savings Account (ESA): Finally, Coverdell plans are a great way to save for your child's education. Contributions to a Coverdell are not tax-deductible, but distributions for qualifying education expenses are untaxed. You have complete control over where the money is invested, which is a major advantage. In 2019, the contribution limit is $2,000.

If you use any of the tax-advantaged accounts above, any capital gains you earn from selling investments within the account, along with any dividends you receive, will be tax-free.

If you're using an ordinary taxable brokerage account, make sure you hold your investments for at least a year (or much, much longer), as this will lower your capital gains tax rate substantially.

Find good companies and hold those positions tenaciously over time to yield multiples upon multiples of your original investment.

Different approaches to beating the market

As I mentioned, when it comes to the specifics of beating the market, there's no one-size-fits-all approach that's guaranteed to work. The four steps above are the necessary price of admission. After that, it's up to you to do your own homework.

Buffett does it his way while Schloss did it another way. Ichan does it his way while Lynch did it another way. Tepper does it his way while Andreessen does it another. The greatest investors ever have opposing strategies. Learn from all of them & don't be afraid to be different.

Ian is specifically calling out many of the investing greats:

Warren Buffett has beaten the market by focusing on moats (i.e., competitive advantages) and valuation.

Allow for a "cooling-off" period of at least 24 hours (but hopefully more) between when a piece of news breaks and when you decide whether you should make changes to your portfolio as a result. So if your company announces terrible earnings, don't hit the "sell" button as a knee-jerk reaction. Allow your emotions to die down, because emotional investing is extremely hazardous to your returns.

Once you have filled out your portfolio, reassess your positions once or twice per year, but never more. The fundamentals of a business rarely change on a three-month timeline -- but that's how many investors view the stock market. Instead, dedicate yourself to longer time frames to help separate the signal from the noise.

And above all else, keep your end goal in mind. While "beating the market" is a pursuit that can lead you to substantially grow your wealth, it's not healthy to make it the cornerstone of your life.

Instead, make sure investing serves a bigger purpose in your life -- like achieving financial independence, helping to send your kids to college, or whatever else matters to you. When you have a nest egg to do that, it's entirely possible that it's time to stop focusing on "beating the market" and turn your attention elsewhere.

In the meantime, happy investing!

Author

Brian Stoffel has been a Fool since 2008, and a financial journalist for The Motley Fool since 2010. He tends to follow the investment strategies of Fool co-founder David Gardner, looking for the most innovative companies driving positive change for the future. He also mixes in risk-management strategies he's learned from Nassim Nicholas Taleb. Follow @TMFStoffel